I’ve seen/heard the term “portfolio heat” many times. What is that exactly in relation to trading? Does it have anything to do with individual bet sizing?
Yes, think of it as the sum total of the risk you are taking over your entire portfolio including both long and short positions.
For example, if you have 4 trades on (either long or short) and you are risking 2% on each, you could say that your “portfolio heat” is 8%. If you have 10 positions @ 1%, you have 10% portfolio heat. If you have 26 positions with 0.50% risk each, you’re looking at 13% portfolio heat.
Risk here is defined as the risk to total capital (as of right now, marked to market). You calculate that as the (distance between your entry and exit) multiplied by (# contracts). You are never playing with the market’s money. Once you have unrealized gains, it’s your job to keep them as best you can.
Once you have your trading rules solidified, you can calculate what the optimum level of portfolio heat is for your systematized rules. You might find that your model has high expectancy, but the results are too volatile to market. Then you go back to the drawing board and cut individual risk per trade, what is sometimes referred to as bet size.
The level of heat you are comfortable with might not be marketable for public funds. Most allocators are looking for great risk-adjusted returns, as opposed to anything over 50% net of fees for example – something that would indicate more times than not that the trader has a high portfolio heat number. (See Staggering Growth).
Portfolio heat is tied to your temperament and personality type. If you are a risk lover, you’ll have a high heat %. The converse is true to more conservative traders. That is why I believe that self-awareness and emotional intelligence are the most important things a trader can and should learn. The math here can be taught to anyone who knows algebra.
Where it’s important is that as you evolve in your trading career and you move towards handling public funds, you’ll likely evolve to having a constant % for portfolio heat. You can set up a rule such that no new trades are entered neither long nor short until an exiting position is offset (profitably or not).
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